Commercial paper

Definition

Commercial paper is a short-term, unsecured debt instrument issued by corporations to raise funds for immediate needs, such as inventory purchases or operating expenses. It typically has maturities that range from a few days up to 270 days and is an important tool in the global money markets, providing companies with quick access to capital without the complexities of bank loans.

5 Must Know Facts For Your Next Test

1. Commercial paper is typically issued at a discount to face value and does not pay interest in the traditional sense; instead, investors earn a return based on the difference between the purchase price and the maturity value.
2. This financial instrument is often rated by credit rating agencies, with higher-rated paper considered less risky and more desirable to investors.
3. Corporations usually rely on commercial paper when they have strong credit ratings since it's an unsecured form of borrowing.
4. The issuance of commercial paper is highly influenced by the prevailing interest rates in the economy; when rates are low, companies are more likely to issue it.
5. During financial crises, the commercial paper market can face significant disruptions, impacting companies' ability to secure short-term funding.

Review Questions

• How does commercial paper serve as a financial tool for corporations, and what advantages does it provide compared to traditional bank loans?
  • Commercial paper serves as a quick source of funding for corporations, allowing them to meet immediate cash flow needs without the lengthy approval processes associated with traditional bank loans. The main advantages include lower issuance costs, faster access to capital, and flexibility in terms of maturity. Additionally, because commercial paper can be issued at a discount rather than paying periodic interest, it offers corporations a cost-effective method for short-term borrowing.
• Discuss the role of credit ratings in the commercial paper market and how they affect the terms of issuance for corporations.
  • Credit ratings play a crucial role in the commercial paper market as they help investors assess the risk associated with investing in specific issuers' notes. Higher-rated commercial paper indicates lower default risk, allowing corporations to issue at lower interest rates and attract more investors. Conversely, lower-rated papers may face higher yields due to increased perceived risk, making it more expensive for companies to borrow. Thus, maintaining a strong credit rating is essential for corporations looking to utilize commercial paper effectively.
• Evaluate the impact of economic fluctuations on the commercial paper market and its broader implications for global liquidity.
  • Economic fluctuations significantly impact the commercial paper market by influencing both the demand for and supply of this short-term financing option. In times of economic stability, businesses are more confident in their ability to repay their debts, leading to increased issuance of commercial paper. However, during economic downturns or financial crises, investor confidence can wane, causing disruptions in the market that reduce liquidity. These fluctuations can result in tighter credit conditions for companies reliant on commercial paper for funding, which can subsequently affect their operational capabilities and broader economic activity.

Related terms

Treasury bills: Short-term government securities issued by the U.S. Treasury with maturities ranging from a few days to one year, used to finance government spending.

Certificate of deposit (CD): A savings certificate with a fixed maturity date and specified interest rate, offered by banks to individuals and institutions as a time deposit.

Money market funds: Investment vehicles that pool money from investors to purchase short-term, high-quality investments like commercial paper, Treasury bills, and CDs.